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HISTORY Options have always existed “Real Options” examples are numerous - the right, but not the obligation, to undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. Example 1: an aluminium smelter which uses a series of inputs (alumina, power, labour) to produce an output (aluminium) and has the option to close down when the input costs exceed the output costs. Example 2: a power station Example 3: A common option that exists is that which allows a mortgage borrower to repay his loan earlier – this corresponds to a callable bond option. 21 May, 2013

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HISTORY OF OPTIONS Formalisation 332bc- The earliest recorded option believed to have been used in ancient Greece by Thales of Miletus who bought the right to use a number of olive presses in the following Spring in anticipation of a larger than usual olive crop. We do not know how Thales valued this option! Standardisation and listing 17 th Century, first listing on an exchange in London – on tulips – outlawed 1733-1860 Standardisation, trading as we know it today occurred in 1973 on CBOE (stock options) 21 May, 2013

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HISTORY OF OPTIONS There is much literature available on the many types of options 21 May, 2013

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HISTORY OF OPTIONS …and also plenty on how to risk manage them. 21 May, 2013

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THIS PRESENTATION Discussion pertains to simple listed options (American or European style) on single assets such as commodity futures Factors that need to be considered in the design of an option contract 21 May, 2013

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THE PURPOSE AND FUNCTIONS OF OPTIONS Speculation Options can be used to: Take directional views on markets Take views on volatility of markets Limit downside in a trade In general, a universe of pay-out options can be tailored to specific views (timing, potential market move, etc) 21 May, 2013

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OTHER BENEFITS OF OPTIONS Volatility as an asset class The existence of a liquid options market in an underlying asset allows an independently traded volatility market. This attracts additional users of the options contract who will be more interested in the volatility characteristics of the option as opposed the directional characteristics) and this will improve liquidity 21 May, 2013

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OTHER BENEFITS OF OPTIONS Correlation as an asset class Inter product and intra product options (options on timespreads, options on commodity spreads) allow for an independently traded correlation market Once again, this will attract liquidity from traders who wish to express views on the correlations between futures and thus increase overall contract depth. The existence of volatility and correlation as observable, tradable parameters allows for positive externalities. Some assets are simply options (see previous examples) and it is possible to theoretically model and value these assets as options which means that the “time value” as well as the “intrinsic value” of the asset can be computed. 21 May, 2013

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Systematic build-up/concentration of risks (dominant positions, large pockets of risk) Margining Monitoring – pre-trade, post-trade transparency Position limits 21 May, 2013 MAJOR RISKS IN DAY TO DAY OPERATION Operational risks with large adverse financial impacts Mistakes upon expiry can be limited through well thought through expiry process End of day “double blind” reconciliation at clearing house for all positions to eliminate misbooked/unbooked trades

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Non-linearity of risk can result in rapid acceleration of counterparty risk intra- day Stress testing of portfolios Position reporting/understanding of market structure 21 May, 2013 MAJOR RISKS IN DAY TO DAY OPERATION

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Inappropriate use of contracts Over hedging, Overly large speculation/mismanagement of option risk – especially from shorts Shadow banking Hiding losses Off-market transactions (in the money options) Mistimed transactions Cash movements between accounts Inappropriate use of credit lines Excessive leverage can cause credit line usage to increase rapidly (mitigated by stress testing, monitoring of risks) In-the-money options can be used to dramatically increase credit line usage (pseudo loans) Ability to identify linked accounts across market 21 May, 2013 MAJOR RISKS IN DAY TO DAY OPERATION

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Regulatory framework defines acceptable use of product and provides a foundation upon which market structure can be designed, built and run. With thoughtful design of regulatory framework it should not be necessary for the regulatory body to intervene in day to day running of markets. 21 May, 2013 MAJOR RISKS IN DAY TO DAY OPERATION

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DESIGNING A REGULATORY FRAMEWORK Regulator works closely with exchanges to design clear rules, reporting requirements, sanctions system to: Protect end user of derivatives (misselling, inappropriate contract use) Protect against market instability (credit events, concentration of risk) Protect against market abuse (inappropriate contract use, manipulation of prices) Rulebook can be designed at regulator level to ensure consistency of rules across exchanges but different markets will require specific rules (commodity markets versus financial markets) and it is possible that variants/adaptions on standard regulatory rulebook will be required. Exchanges should capture sufficient data to be able to either identify rule breaches or potential risk issues in real time or historically (patterns) Ensure that sanctions can be effectively applied in the case of problems (clarity of rulebook, clarity of breach) either at Exchange level (minor breach) or Regulator level (major breach) 21 May, 2013

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Regulation needs to encompass wholesale and retail users of the exchanges: Requirement for strong corporate governance – authorisation/signoff at all levels Requirement of accountability throughout corporation Requirement of openness – full disclosure of house account, client accounts and retention of all relevant records End user protection (misselling, protection of funds, netting of accounts) Remuneration culture (moral hazard) Enforcement Must be credible, effective and targeted Applied by Exchange or Regulator Clear sanctions Fines Negative publicity Revoking of licence Prosecution 21 May, 2013 DESIGNING A REGULATORY FRAMEWORK